Monday, November 3, 2014

Risk Management and the Interagency Diversity Standards: Opportunity and Peril

Change is afoot in the financial services industry as key elements of the Dodd-Frank Act (finally) take root. Three regulatory initiatives in particular are now at the forefront of bank compliance efforts. First, under section 165(h) of the Dodd-Frank Act, the Federal Reserve issued Enhanced Prudential Regulations (Reg. YY) for large bank holding companies which will take full effect on July 1, 2015. Second, the Office of the Comptroller of the Currency has similarly promulgated new risk management standards applicable to large insured banks and thrifts. Third, the Fed, the OCC, the FDIC, the SEC, and other financial regulators have proposed interagency guidelines for assessing the diversity policies of regulated entities, issued pursuant to section 342(b)(2)(C) of the Dodd-Frank Act.

I have previously blogged about the new risk management standards applicable to banks and other financial institutions. I also have previously blogged on the positive impact of cognitive diversity. In this post, I argue that these new regulatory initiatives should be taken as an invitation for every firm to upgrade their policies to fully embrace cognitive diversity and to move to enhanced risk management policies and procedures. While each firm should customize its approach for its business environment, the empirical evidence suggests that large firm value and performance gains are possible for firms at the cutting edge of these issues. On the other hand, risk and diversity mismanagement can inflict huge costs on firms.

In past posts I have summarized the outsized gains in financial performance for those firms taking a more optimal approach towards ERM. Similarly, it is clear that enhancing the cognitive diversity of a board leads to outsized performance gains. Thus, one recent study found that sound ERM is associated with firm value gains of up to 20 percent. Another recent study found that firms benefiting from the cognitive diversity implicit in having an attorney on the board enjoy a 9.5 percent valuation advantage. These are simply a sample of studies that find such gains.

There are no studies that I know of that assess the positive gains available to firms that seek to optimize their approach to both ERM and diversity, simultaneously.

Logically, ERM and embracing diversity go hand-in-hand. For example, diversity policies that prohibit any hostile environments for any workers will give a firm an advantage in worker productivity as well as limiting the risks from Title VII litigation. Firms should assure they foster business cultures with a zero tolerance approach for discrimination and harassment. Broadly embracing diversity assures the most skilled workforce possible. Similarly firms should seek more diverse leadership can draw upon broader cognitive insights to assure that the firm adhere to ethical norms and expectations that mirror those of diverse constituencies ranging from investors, employees, consumers and suppliers. In sum, diversity is critical to the sound management of legal, regulatory, and reputational risk.

Moreover, aside from the potential gains from optimizing a firm’s approach to risk management and diversity, business leaders should also consider the likelihood of negative outcomes from failing to bring the best learning to bear on these issues to their firms. We learned from the financial crisis that less diverse firms engaged in risker subprime lending activities. Financial firms with superior risk management policies also fared better during the crisis. Failure to embrace ERM and cognitive diversity leads to financially impaired performance.

I will be writing more on these new regulatory initiatives. Today I simply write on a single point: all businesses should reflect on the opportunities as well as the perils presented by the best learning on ERM and diversity management. As I will show in my next posts, these new regulations reflect and further our understanding of ERM and diversity management.

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